Month: November 2011

I think that BHP is set up for a short term drop, but will be a fantastic performer over the next few years.
I am basing this primarily on key statistics, the underlying trend, the analyst’s bias, and the recent price swings.
BHP is a mining company that has become instrumental in supplying companies in the developing world with the iron ore they need for steel, and other various minerals.
A glance at the fundamentals seems to confirm that the underlying trend, i.e. the thirst for minerals in the developing countries, remains strong. BHP is pulling net profit margins above 33%, because of a high price environment for minerals. It has a low debt load, (<30% Debt/Equity), and a high return on equity (44%). What is fascinating is that the stock now has a P/E below 9.
The price has been dropping recently, an effect of a change in the prevailing bias in the markets. Market participants are expecting that the European credit crunch will result in reduced lending to the developing countries. Thus, these countries will not have enough money to continue construction at current rates, and the demand for minerals will die down.
I believe this logic is flawed, because certain Asian countries, like China, now have enough funds to lend internally, so the effect of the European credit crunch there will be minimal. I think that market participants have overcompensated for the European credit crunch.
However, I don't think we have reached the bottom of this price drop. I think that recent price drops are confirming the bias that market participants have set, and this price move will last until a clear resolution to the credit crunch has been reached.
BHP may be an interesting pick to begin researching, and snatch up sometime in the next few weeks. The underlying trend is a multi-year trend, and the price is being affected by a bias that will not last longer than a year.

The underlying trend here is not likely to be affected by the price moves, because the company has enough cash on its balance sheet to finance its own growth, and in fact, buys back its stock aggressively. When a company is a net purchaser of shares, price drops can naturally be corrected by a strong underlying trend, because this gives the company enough cash to put upwards pressure on the price.

The collapse of the foreign sovereign debt market has made U.S. treasuries relatively more attractive. In addition, bond investors will be looking to U.S. companies with high credit ratings and low debt/equity ratios instead of sovereign debt in general.

This could have long lasting effects, and set off a reflexive chain of events. As investors purchase the bonds of U.S. companies, the yields on these bonds will decrease, making it much easier to sustain larger levels of debt than it has been in the past.

Further, the larger amounts of credit available to companies will allow them to grow at a faster rate. Thus, the companies can shore up their balance sheets and issue new bonds at the same credit rating to continue to grow.

The relationship with stocks will also be reflexive. As the companies grow, their stock prices will also increase. This will decrease the debt/equity ratios of the companies, and make the companies bonds look even less risky.

This situation depends on the companies in question being able to grow their earnings using their credit. Thus, we should look for companies that have growth opportunities, but have been limited thus far because they have not been willing to issue new debt.

Some companies that come to mind are TMO, Thermo-Fisher Scientific, which was one of the first companies to issue new debt at low interest rates following the U.S. downgrade, and CAT, Caterpillar, which relies on high debt loads to fund their manufacturing. CAT is currently sitting on a large backlog of orders.

These are not recommendations necessarily, but they are starting points for further research.

This situation could grow untenable if the companies have no further room to grow. I believe that a collapse in many non-Asian emerging markets is imminent, as a result of the contraction of European credit. Ironically, this could spark a short term rise in U.S. stocks in early 2012, as money managers to pull funds out of riskier emerging markets, like Eastern Europe, and put them into more secure growth stories, like China, or value stocks in America.

But longer term, this may hurt American companies that do business overseas, by contracting their growth opportunities. Further, the high U.S. unemployment will eventually limit U.S. consumers ability to spend, unless new solutions are found. Thus, the situation on a longer term than 1-2 years may not continue, but I believe that the stock market can continue to rise for the near future, on a debt-fueled growth spree.

I sold my Apple shares a few weeks ago, and I am growing more convinced that it was a wise decision.

Why? I am not convinced on the performance of the stock for the foreseeable future.

I still believe the company has great prospects, and will continue to make a lot of money. But I do not believe that the stock price will continue to rise as it has in the past.

Apple has continually benefited from a positive relationship between expectations and reality. The company provided guidance that was conservative, and analysts began to ignore the guidance. But, for several years straight, analysts’ expectations proved to be conservative as well, as Apple continually blew away earnings expectations.

However, this is changing. Because of its continued earnings beats, the analyst community has gotten used to less and less conservative expectations. And now, the company has changed its earnings guidance policy.

The change was noticeable on the prior earnings conference call. Apple revised guidance upwards for Q4, which caused analysts to overshoot that guidance. As a result, Apple did not beat the analysts expectations for Q4. The stock subsequently dropped from the 420 range to sub 400.

Apple management pointed to the delayed launch of the 4S iPhone, and upped guidance for Q1 2012, based on high expectations for 4S sales.

Now, this puts tremendous pressure on the company to perform. Analysts will still expect higher earnings than the guided figures. If Apple cannot meet these figures, it could set off a drastic change in events.

Why drastic? Because the fundamentals of Apple’s operation are directly tied to its stock price. Ever since 2001, the fundamentals of the company and the price of the stock have enjoyed a positive reflexive relationship.

Apple has been a net seller of shares every quarter. As expectations increase for the company, the stock price increases, and Apple can issue shares at a higher price, raising more capital for research and development and operational costs.

Apple’s continued growth drives costs higher and higher, but so far, these costs have been mitigated by the simultaneous rise in stock prices. However, if stock prices should begin to fall, operational costs will become a larger and larger burden on the company, and could begin to drain its vast cash reserves.

Now, of course, Apple is not wanting for cash. Its $81.55 billion would be able to cover its 2011 operational costs ($19.5 billion) four times over. However, it partially financed those costs with $831 million of stock issues.

Recent news seems to point to 4S sales not being as robust as previously anticipated:

“sales of the iPhone 4S have not been as strong as those concluded in the pre-sales period”

Right now, the risks to the stock price are too large. Though Apple would seem to be a value play at its current prices, it does not pass a sufficient margin of safety. There are far better opportunities in the current market. We will have to wait and see if results can again surpass expectations for Q1 2012 to tell if the Apple juggernaut can continue.